Tuesday, May 21, 2013

Earnings, Multiples and the Stuff We Overlook at Market Tops

The new record highs for the S&P and DJIA indices has spurred a great deal of discussion about what's driving the market to new highs. The doubters look to the Fed and the Bernanke Put as setting a floor under equity prices. The bulls look to relentless corporate earnings and fattening balance sheets to justify valuations.

Thus as it's always been, a battle of bulls and bears providing equilibrium to the markets. With the macro data once again turning negative (for the fourth straight spring cycle), Asia weakening and Europe part in recession and part in full-scale depression, we are compelled to dive deeper into the puzzle of US corporate earnings for answers. After all, when the US economy stalled in 2010 as stocks steadily advanced, the bulls educated us all on the percentage of US multi-national sales that came from a then healthy EU and a roaring Germany. When these markets faltered, they redirected us to Asia. These same voices are now advising we look inward to corporate balance sheets.

And, no doubt, balance sheets are in great shape (at least for large companies) thanks to the Fed greatly reducing refinancing costs and boosting stock prices. But balance sheets bolster corporate solvency and credit-worthiness not earnings. It's peculiar testimony to the uncertain operating environment corporations face that their highest and best use for cash is to recycle it to shareholders. The accelerated use of share repurchases may be driving stock prices higher, but shrinking the balance sheet is not a formula for organic growth in any textbook we've seen.

Earnings, however, are different. They are clearly a sign of growth, purpose and value, even if you overlook the lack of top line revenue from which they derive. But earnings growth is also slowing and valuation metrics are increasingly stretched.

Goldman's Chief Equity Strategist David Kostin today released an uber-bullish call on US equities. The essence of his model is that a forecast 2013 earnings growth rate of 11.3%, accompanied by further multiple expansion, must lead to higher share prices. Well, that's simply arithmetic, isn't it? Assuming you accept the assumptions.

Kostin cites the current market p/e multiple as a forward multiple of foretasted earnings, as is increasingly the common practice, rather than price over trailing twelve month earnings (TTM) as until fairly recently was accepted market convention. This is undeniably what tends to happen at market tops when valuations get stretched: people create new and improved metrics. Those of us who lived through the tech boom/bust of the late 1990s, early 2000s will recall how during the boom cycle p/e ratios were upgraded to p/e/g ratios, arguing that p/e ratios must be adjusted by the growth rate of earnings to properly value modern high tech companies against stodgy old makers of laundry soap and toothpaste. No one seemed to mention p/e/g ratios beyond 2001.

Kostin references the current S&P market p/e as 13.3 on its way to 15 by 2013 and 16 by 2015. Hmm. Well, these are first and foremost forwardly looking p/e ratios, because the TTM on the S&P as of today is a hearty 19.2 (for the Russell 2000, by the way, it's a juicy 35.66). But this phenomena of overstating future earnings, only to downwardly revise throughout the year, has been the pattern of the last two years. So now Kostin advises that we approach 2013 with a forecast for earnings that may be 10% too high (relative to what we may actually realize) and then slap a greater multiple on those earnings that will undoubtedly bring the p/e TTM measure into nose bleed territory.

Add to this the practice of borrowing to fund share repurchases and corporations easily meet higher EPS targets not through growth in operating earnings, but through a lower share base. As the p/e is commonly calculated by simply taking the price per share and dividing by earnings per share, an inflated EPS (as a result of share repurchase) will artificially lower the p/e. These are the kind of things we overlook when trying to convince ourselves that we're operating within reason at market tops.